Why We Expect the Fed to Cut Interest Rates in 2023
Four key takeaways from our updated interest-rate and inflation forecast.
Despite the Federal Reserve’s decision last week to hike interest rates and ongoing economic turbulence, our long-term optimism about gross domestic product and inflation remains largely unchanged.
We think the Fed is slowing the economy enough to help rein in inflation without provoking a major slowdown, and we're projecting annual real GDP growth rates to remain in positive territory. Although real GDP dropped in the first half of 2022, we don’t think this marks a true recession, and we expect growth to bounce back later in 2022.
We expect the Fed will pivot to easing monetary policy in 2023 as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern. The full analysis is detailed in our 2022 U.S. interest-rate & inflation forecast.
The inflation analysis is critical to our near-term projections for GDP and interest rates. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than we expect.
As long as the Fed is allowed to shift to easing in 2023, GDP should continue trending upward and then accelerate in 2024 and 2025. Housing, which is the most interest-rate-sensitive major component of the GDP, will drive much of the fluctuation in GDP growth. Lower rates in 2024 and 2025 will be needed to improve housing affordability and thereby resuscitate demand in the housing market.
Since our last update, we've further lowered our near-term GDP forecasts. Near-term measures of economic activity have come in weaker than expected in recent months, as marked by the 0.9% annualized drop in second-quarter GDP. Altogether since the start of the year, our near-term GDP forecasts have come down substantially owing to supply shocks (especially the war in Ukraine) and a heightened determination from the Fed to fight inflation with tighter monetary policy.
As shown below, we expect GDP growth will bounce back starting in 2024 as the Fed pivots to easing. Resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again. Increases to our GDP growth forecasts for 2025-26 partially make up for our downward revisions for 2022-23.
Though these GDP forecasts for 2022 and 2023 are slightly more bearish than current consensus, we’re far more bullish in the longer run.
Based on available long-run forecasts, we're expecting about 2.5% more cumulative GDP growth than consensus through 2026. Consensus remains overly pessimistic on recovery in the labor supply and has generally overreacted to near-term headwinds.
Our five-year GDP forecasts are driven by our detailed analysis of the labor market and the other supply-side building blocks of the economy.
Our inflation forecasts for 2022 have edged higher, as supply disruptions now look to be taking somewhat longer to resolve than previously expected.
We're still expecting inflation to come down dramatically in 2023 and later years as supply constraints are resolved. The downward revisions to our GDP forecast, shown on the chart below, also mean a more negative output gap in the near term than we expected, which will cool off inflation further.
On inflation, our views diverge sharply from consensus after 2022. Bond market breakevens imply a similar view as consensus on inflation.
While consensus has greatly given up on the "transitory" story for inflation, we still think most of the sources of today's high inflation will abate (and even unwind in impact) over the next few years. This includes energy, autos, and other durables.
Combining these factors with monetary policy tightening, we expect inflation to undershoot 2% in 2023 and 2024. Worries about inflation broadening out into the rest of the economy (including via high wage growth) look overblown.
Long-term forces—far outside of the control of the Fed—have acted to push down interest rates in the United States and other major economies for decades.
In other words, the natural rate of interest has shifted downward because of demographics and slower productivity growth, among other factors. These factors will keep interest rates lower for longer.